Monday, 31 May 2021

Fractional reserve banks create money / liquidity?


Douglas Diamond, Philip Dybvig and Raghuram Rajan have claimed over the years that while fractional reserve banking gives rise to bank fragility and bank failures (not to mention bank crises like the 2007/8 one which lead to tens of millions losing their jobs worldwide) there is at least the compensating advantage that fractional reserve creates money / liquidity. See abstract of their NBER working paper No 7430.

Unfortunately there’s a flaw in that argument which is that governments and central banks can create any amount of money any time simply by pressing buttons on computer keyboards and all without the above attendant risk of bank crises and tens of millions being thrown out of work! Indeed a system where government and central bank are pretty much the only money creators is what full reserve banking consists of. Thus it’s a bit debatable as to whether money / liquidity creation by fractional reserve really counts as a merit in fractional reserve.

Isn't that a bit like arguing that while the injuries that result from drunk driving involve serious costs, drunk driving does at least have the merit of keeping medics employed?

To repeat, the above three authors are not any old three authors. Rajan is former governor of India’s central bank and those three have been cited well over two thousand times in the literature. (For confirmation of that two thousand figure, see top centre right of this version of an article of theirs entitled “Bank runs, deposit insurance and liquidity”.

Of course, that is not to say that under full reserve there would be a total absence of “boom and bust”. But certainly the highly risky “borrow short and lend long” policy which is the basis of fractional reserve greatly exacerbates booms and busts. (Incidentally “borrow short and lend long” is often referred to in economics as “maturity transformation”, but I’ll stick with the former phrase here.)

But there is another weakness in the idea that money creation is a saving grace of fractional reserve, which is as follows. It is actually quite unnecessary to deliberately or officially adopt full reserve banking if the extent of borrow short and lend long is curbed. That is, the benefits of full reserve will appear AUTOMATICALLY by simple reason of the latter irresponsible aspect of fractional reserve being curbed or banned. Reasons are as follows.

Regardless of what bank system is in operation, people and firms will try to obtain the mix of assets they want, liquid and illiquid. E.g. if people do not have the stock of money they want, they will save so as to acquire that stock. That will cause Keynsian “paradox of thrift” unemployment, thus central bank and government will have to create and spend extra base money into the economy (incidentally, exactly what central banks and governments have done big time in recent years).

Conversely, if people and firms think they have excess liquidity, they’ll try to spend away that excess (e.g. on larger houses) and that will tend to induce government and central bank to withdraw money / liquidity from the private sector so as to curb the demand results from the latter “spend away”.

Ergo, if borrow short and lend long is curbed or banned, there will ultimately be no effect on the private sector’s stock of money / liquidity. Thus the claim by the above three authors that money creation is merit of fractional reserve banking is a bit of a myth: if the latter money creation characteristic were nowhere near as effective as it actually is, that wouldn’t make a scrap of difference, because governments and central banks would automatically be forced to step in the do more of their own money creation – and all without the attendant risk of bank crises and tens of millions being thrown out of work!

Indeed, we have actually made significant moves in the direction of full reserve over the last decade, for the following reasons.

First, the US mutual fund industry has in effect switched to full reserve: that is, funds which invest in anything other than US govt debt are now barred from telling saver /  depositors that their money is safe, i.e. that they won’t “break the buck”.

Second, governments and central banks have, as mentioned above, been forced over the last decade to greatly expand the stock of base money in the hands of the private sector.

Third, Central Bank Digital Currency is being activity considered by several central banks and the Chinese central bank has actually put CBDC into effect on a limited or trial basis. Now if central banks offer totally safe accounts to everyone, the question then arises as to why taxpayers should have to stand behind accounts at PRIVATE banks. Well there isn't much point! And that arrangement, i.e. CBDC plus abandoning taxpayer funded support for private banks equals full reserve banking. 


PS (1st June 2021).   I’ve just noticed that the above three authors do actually give brief consideration to full reserve banking (aka narrow banking), i.e. a system where the state is the only issuer of state backed money (unlike fractional reserve, where money issued by commercial banks is also state backed (via deposit insurance and/or bank bailouts)). Thus I’ll do an article here asap dealing with their objections to narrow banking.

But I’ll deal briefly with just four of their objections right now. Diamond and Rajan say in their NBER Working Paper 7430 that “Our model suggests that such legislation (i.e. narrow bank legislation) would kill bank liquidity creation, and result in less credit being available to borrowers.)

Well first, it’s pretty obvious that narrow banking “kills bank liquidity creation”! That’s the whole point of narrow banking! I.e. it is precisely that liquidity creation (as explained above) that brings bank fragility and bank crises, thus we are better off without that form of liquidity creation assuming there is an alternative and less dangerous form of liquidity creation, which (as explained above) there is.

Second, if narrow banking did result in “less credit being available to borrowers” what of it – as long as demand remains high enough to bring full employment? Numerous economists and others claim there is too much debt, thus if an economy is less reliant on debt based economic activity and more reliant on non debt based activity, it is far from clear what would be wrong with that.

Third, Diamond and Dybvig in their 1986 paper “Banking Theory, Deposit Insurance, and Bank Regulation” claim that “…it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity.”

Well that’s a bit like saying it’s a waste of time passing laws against bank robbery because “it will be impossible to control” the new assortment of bank robbers who replace bank robbers put out of business by anti bank robber legislation.

In other words, legislation aimed at stopping all large and medium size banks engaging in the fraudulent “borrow short and lend long” activity would be easy to implement. Mutual funds in the US are already barred from that activity. Of course a few small banks and similar institutions might try to evade the rules, but it makes not a blind scrap of difference what rules are in place, there will always be some naughty individuals who try to evade the rules.

Fourth, Diamond and Dybvig describe narrow banking as a "a dangerous proposal". Well now that's a bit of a joke given that the existing (fractional reserve) bank system caused a major crisis in 2007/8 which resulted in tends of millons worldwide being thrown out of work and a ten year long recession!

To summarise, the above three author’s objections to narrow / full reserve / 100% reserve banking look about as feeble as the objection which former governor of the Bank of England, Mervyn King raised, namely that banks would object to their activities being restricted, which (as I point out here) is a bit like saying anti bank robbing legislation is undesirable because bank robbers would object to it.

P.S. 8th June 2021.    Two further fundamental weaknesses in the idea that fractional reserve creates liquidity are as follows. But first, let’s be clear on the definition of the word liquidity.

The Oxford Dictionary of Economics starts its definition of liquidity with, “The property of assets, of being easily turned into money rapidly and at a fairly predictable price.”

Now where one of the above mentioned full reserve mutual funds takes money from saver / investors and lends the money out or invests it, the stakes that those saver / investors have in the firms to which the mutual fund has loaned money are far more liquid that were a saver / investor lends on a peer to peer basis. I.e. if you buy into a mutual fund – any mutual fund – there’s a good chance you’ll be able to turn your investment back into about the same amount of cash that you originally put into the fund. And that constitutes a “fairly predictable price”. Ergo the claim that fractional reserve banking creates liquidity is rather diminished by the fact that full reserve also creates liquidity.

But another weakness in the idea that fractional reserve creates liquidity is as follows. Fractional and full reserve are essentially just two ends of a spectrum: that is, where an entity that lends out money has a high capital ratio, it is ipso facto towards the fractional reserve end of the spectrum. And where it has a low capital ratio, it is towards the full reserve end of the spectrum.

Now as one moves from the full reserve to the fractional reserve end, stakes that depositors have in the entity become more “predicable in price”, while shareholders’ stakes become less so: indeed, shareholders can easily be wiped out given a high ratio. And that raises a rather big question: does moving from the full to fractional end of the spectrum actually create any liquidity at all? Certainly the liquidity creating effect is less spectacular that fractional reserve bank enthusiasts claim.

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